Although market strategists are rightly concerned about Europe, the U.S. economy and a slowdown in China, the one thing all seem to agree on is that the market is cheap.One guest after another on financial TV states that stocks are undervalued and no one ever challenges them.In our view such assertions are unsupported by the historical data and are a result of flawed reasoning.

The analysts state that the S&P 500 at about 1200 is selling at about 11 times estimated 2012 operating earnings of about $108, well below the historical average of 15 times.In addition when the $108 of earnings is multiplied by 15 the result is a target of 1620 on the S&P 500 by the end of 2012.In other words they are multiplying 12-month forward estimated operating earnings by 15.

There are a number of major problems with that approach.Yes, it is true that over a long period of time the S&P 500 has sold at an average of 15 times earnings.But the earnings used in the calculation were reported (GAAP) earnings rather than operating earnings and the earnings were actual trailing earnings rather than year-ahead earnings.Operating earnings were not used until the mid-to-late 1980s, and "EXCLUDE WRITEOFFS" of various kinds as determined arbitrarily by corporate management.Generally operating earnings are far higher than reported (GAAP) earnings.Let's not forget that GAAP stands for "Generally Accepted Accounting Principles", and that operating earnings do not.If the historical average P/E was calculated on the basis of operating earnings the P/E would be much lower.

Another hazard is the use of estimated 12-month forward earnings.The estimates are almost always wrong and most often on the high side.For instance the estimate for 2001 was $54.20 and came in at $36.85.Reported earnings that year were $24.89.Similarly, the estimate for 2008 was $99.15, but came in at only $49.54 while reported earnings were a paltry $14.88.

Another big problem is the volatility of year-to-year earnings which constantly fluctuate from high to low and back again.Historically the market has valued peak earnings at an average P/E of 12 while valuing trough earnings at a P/E of 18.The way to solve this problem is to smooth earnings over a period of years and calculate normalized earnings.Our method of doing this is to take a nine-year annual average of actual reported earnings moved forward to the current year.On this basis current normalized earnings of the S&P 500 is $72.and the P/E with the index at about 1200 is 16.7.Since secular bear markets typically bottom at P/Es of 10 or under, the market from this point has the potential to drop a long way.